Why You Can Expect Double-digit Inflation To Make A Comeback

July 09, 1986|By Richard B. McKenzie. Richard B. McKenzie is coathor of ``Regulating Government: A Preface to Constitutional Economics`` (Lexington Books, 1986). He is John M. Olin visiting professor at the Center for the Study of American Business at Washington University in St. Louis. He is on leave from Clemson University.

With the annual inflation rate dipping below 4 percent, double-digit inflation appears to have been licked. Indeed, the relatively stable and low market interest rates suggest that even investors are reasonably confident that it is a problem of the past.

However, the growing confidence that inflation will not return is misplaced, founded on fortuitous anti-inflation circumstances that cannot be expected to hold for long. For six important reasons, we can expect to see inflation return, leading perhaps to double-digit rates by the late 1980s or 1990s.

First, inflation in the United States has been suppressed recently in part by a combination of these favorable conditions:

A pool of unemployed resources at home and abroad was available in the early and mid-1980s when the domestic economy was resuscitated, beginning in 1982, by expansive monetary and fiscal policies.

An appreciation of the dollar in effect has allowed American consumers and businesses to vent their excess demand for goods and services on progressively cheaper foreign goods and resources.

The collapse of OPEC has made more energy available at lower prices.

A surge in international competitiveness of foreign industries has had the effect of holding down labor cost increases and enhancing U.S. production efficiency.

A dramatic drop in the velocity (or turnover rate) of the money stock, inspired in large measure by decreasing inflationary expectations, has meant that much of the recent growth in the money stock has been absorbed into bank balances.

The second reason we can expect inflation to come back is that the Federal Reserve has grown accustomed to expanding the money stock (as measured by M-1) at an annual rate of 12 percent during the last year with no appreciable effect on the inflation rate. Unless the Fed changes its ways, it will not recognize that aggregate supply and demand conditions have changed until long after inflation has once again become a problem.

Third, monetarism--a theoretical framework whose basic premise is that growth in the money stock should be strictly controlled--has for all intents and purposes been shelved as a guiding ideology among the Fed`s board of governors. We must worry when the keepers of the money stock are controlled not by external checks--i.e., rules for the conduct of monetary policy--but only by their own discretion that may be guided by changing fads in macroeconomic theory.

Fourth, for the time being, control of inflation appears to be excessively dependent on two principal personalities, Federal Reserve Chairman Paul Volcker and President Reagan. Given the low inflation rate for the last several years, it is likely that their successors will not be so stubbornly anti-inflation as they maintain they are.

Fifth, the progressively lower interest rates are encouraging more and more people to assume more and more debt for homes and businesses. Because debtors gain from inflation, political opposition to it is waning while political support for more inflation is expanding with every increase in private debt.

Granted, growth in debt also spells growth in credit, and creditors have their private reasons for opposing return of the inflationary spiral. Unfortunately, the growth in number of creditor-voters with each $1 billion expansion in private debt tends to be far less than the growth in the number of debtor-voters. This is true simply because saving tends to be concentrated within high-income groups and because each credit institution lends to many different people.

Sixth, and most important, the $1 trillion in federal debt incurred over the last five fiscal years and continuing large federal deficits increase the attractiveness of inflation to the federal government.

Inflation offers members of Congress and the administration a surreptitious means of reneging on debt obligations. When the total federal debt is $3 trillion, which it may approach in the early 1990s, each 5 percentage points added to the inflation rate reduces the real federal debt by $150 billion a year.

Such a reduction in the real federal debt is an indirect and disguised form of taxation. Nonetheless, it is a source of revenue that will not likely remain unexploited by politicians who wish to reduce the burden of their profligate spending of past fiscal years.

Clearly, these real debt-reduction benefits can only be realized by the federal government if people are fooled into believing that inflation is a problem of the past. If they aren`t fooled, interest rates will be adjusted upward by market forces to account for the expected reduction in the real debt.

However, given the recent drop in interest rates, it appears that the market is projecting lower inflation rates, setting the stage for future politicians to reinflate and thereby renege on the federal debt burden, which cannot be expected to stay down for long. A reduction in the real federal debt will enable future politicians to do what comes naturally: spend more than they collect in taxes, raising the federal debt once again.

This is not an encouraging scenario. Indeed, it is depressing, but it is grounded in a fatal flaw of our economic-governmental system: Economic policy is currently being checked only by the forces of politics, and inflation has very powerful political constituencies.